Choosing Between Taxable and Tax Deferred Saving Accounts

Whether to use a tax deferred or taxable savings account isn't a clear decision. There are advantages and disadvantages for both types of accounts. In the table below, I've summarized my view of the tax treatment for tax deferred and taxable saving accounts. Green signifies what I consider an advantage and red indicates what I consider a disadvantage of the account.

	Tax Treatment
Category	Tax Deferred	Taxable
Contribution	Reduces taxable income in current year, except for Roth contributions	After tax money
Earnings	Grows tax free and is not taxed until withdrawal	Taxable each year as earnings occurs
Capital Gains	Ordinary income tax rate at withdrawal, except for Roth and college saving accounts.	Lower tax rate
Dividends	Ordinary income tax rate, except for Roth and college saving accounts.	Lower tax rate
Withdrawal	Retirement accounts are taxed as ordinary income with penalty for withdrawals prior to 59 1/2. College savings account withdrawals are tax free when used for qualified education expenses and taxable otherwise.	No taxes on principal and can be withdrawn anytime and used for any reason
Inheritance	Taxed as ordinary income	Cost basis steps up

Key - Green = advantage ; Red = disadvantage

To me, the best type account will depend on the financial situation of the individual saver and the expected timing of needing the money. Deferring taxes or avoiding taxes is an attractive option for those in higher tax brackets. However, the benefit does come with restrictions, which, if not met, can be costly to the saver. Taxable accounts offer the greatest flexibility, since the money can be accessed anytime for any reason.

From our experience, we found it best to put money in tax deferred accounts that we were very sure we didn't need until retirement. If we thought we might need the money in the next five years (e.g. emergency fund, car purchase, down payment for house, etc.) we put money in a taxable savings account.

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This is not financial, tax or saving advice. Please consult a professional advisor.

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